Matthew Diczok: Thanks very much for everyone joining us today. I'm Matthew Diczok, Head of Fixed Income Strategy. Today is Thursday, May 26th and wanted to talk today about keeping things in perspective. Importantly, always thinking about the second order effects and always remembering that price and future returns are always inversely correlated. What we mean by that is higher prices, while they feel good, really borrow returns from the future and lower prices, while they make us feel worse, do make future returns more attractive. So three important thoughts on that. First off, as we look at both the coincidence and leading economic indicators, the US economy and the global economy are both softening, but that's the first order effect. The second order effect is to not read that as bad news; that is a likely intent in what the fed is trying to accomplish. This is actually what the fed is trying to manage the economy to do. Secondly, obviously one of the largest surprises over the last year has not been just the diversified portfolios are down, but how much fixed income prices are down within that time frame. Again, we would counsel folks not to read too much into that. Not to significantly reduce fixed income especially high quality fixed income after those price declines have happened. Third, you put those together as we mentioned, diversified portfolios - at least over the near term - have seemed not to protect investors. Again, that is not as unusual as some might counsel you. It has happened multiple times in just the last 10 - 20 years and while a near term break in diversification in bonds and equities is concerning and has led to price declines on both asset classes, a lot of times they move back to normal correlation. We are seeing signs of that in markets and again, we would counsel investors not to abandon classically balanced equity and fixed income portfolios. So hitting those points in turn. First off, the economy softening. One of the best leading economic indicators – and that’s what we want to focus on, leading economic indicators, not what’s happening right now, not something like inflation which is a lagging indicator that tells us what had happened in the economy. We want to have an idea of what might happen in the future and there are a number of leading economic indicators. One of the best for the labor market is jobless claims. How many people are being laid off and applying for insurance? We reached a low just recently of about 166,000 which was as low as we've seen since the mid to late 1960s. In fact, as a percentage of either the US population or the actual labor force, this was an absolute all time low in percentage terms relative to that but we've trended up from there. We're now about 200,000 plus of unemployment claims. Now that is a leading indicator that tells you sort of what's happening in the labor market. Stock prices, the S&P 500, is also technically also a leading indicator. So because both of those are leading indicators, they might tell you what's happening to the economy’s future. A lot of times together they move at the same time so those drop in equity prices has coincided with an uptick in jobless claims. They're giving you a similar signal. If you look at all the leading economic indicators in aggregate, they've slowed to a year over year pace of just under 5%. Now they peaked at just over 12% in the post-Covid run up and now under 5% at 4.7%, that is well below the peak we had seen in 2018. A lot of the market action we see right now is reminiscent of 2018. In 2018 the fed had introduced QT, was tightening financial conditions, global economic activity slowed, US economic activity slowed, the S&P dropped almost a full 20% - not quite - by December of 2018, but then the fed pivoted as we say, meaning they changed their course and they started to become easier. A lot of the market activity right now does seem to be similar to 2018. We emphasize again, do not think the first order effect that the economy is softening and get concerned. Think about the second order effect. Inflation is too high right now. It is hurting the US consumer too much. Running at an overall pace of greater than 8% is really weighing on consumer confidence with respect to purchasing large ticket items, cars, appliances and obviously higher mortgage rates are starting to soften the housing market, but this is not a bug, this is a feature. In order to get consumer confidence a little bit higher, in order to have people's wages not lose money in real terms, the fed does want to slow the economy. So the economy’s slowing already even as the fed just embarked on its rate hike path and just starts to remove some of its very accommodative bond buying programs from post crisis. This is what the fed is looking to do. They want to help consumers. They want to do this in a way that minimizes pain. So while they want to bring inflation down, they want to do it in a careful way that maintains an optimal balance between positive business conditions, but not too positive business conditions that lead to higher inflation and so they want to keep corporate health good in a balanced way because at the end of the day how businesses fare - businesses employ a lot of people - that will help how consumers fare. So we've seen a slight change in messaging from different parts of the Federal Reserve. For instance this week we had the Federal Reserve Bank of Atlanta President, Raphael Bostic, say he wanted, ”To see a committee proceed with intention and without recklessness,” and what that has been interpreted to mean, and we’ve seen this in other communications from the Federal Reserve, is that by front loading rate hikes, meaning by doing more rate hikes now instead of increasing the fed funds rate by 25, increasing it by 50 basis points and potentially increasing it by 50 basis points three times in a row. By front loading interest rate hikes it might give the ability of the fed to slow the economy more now and then potentially pause later in this year or the beginning next year if the economy demands it. We want to be clear here. No one knows at this point. Anyone who expresses certainty on this point is likely mistaken. We don't know, the market doesn't know, and the fed doesn't know but it is important for the fed as always to maintain optionality. If they should keep the current pace and the data says that, they should do so. If they need to quicken it, they should do that as well but if they're getting a sense from the market that actually they might have to start slowing the rate of tightening monetary policy, it is good to have them have that option on the table so we need to be careful that they think about the optionality, think about the policy choices, and lead to a correct code conclusion if the data says to do that. To be clear, the market’s interpretation, rightly or wrongly, is that the fed will have to adjust course in the relatively near future. You can look at interest rate futures and they can tell you basically what they think the fed is going to do. If you look at those market forecasts, they say the fed is likely to stop hiking rates when the fed funds rate gets too close to 3% and then actually by the middle of next year to start cutting rates once or twice. So while the market may be right or wrong, it has a fairly consensus view right now that policy around 3% with quantitative tightening that is reducing the fed's balance sheet will be enough to continue to slow the economy, bring inflation down, but not cause a severe recession. So some near term pain as we call it, a drop in asset prices in this type of scenario was likely unavoidable and so we've seen that impact already, but we don't want to overestimate that just because the prices have gone down this much, they're going to continue to go down at that same pace. Bringing us to our second point - we've obviously seen a large drawdown in fixed income prices which has somewhat reversed over the past couple of weeks. We got here because the fed was very certain a year ago that inflation was, “transitory,” and they weren't going to have hike rates and if we're having this conversation sort of a year or so ago, they would have expected zero to one, maybe two rate hikes over the following twelve months. Fast forward to today and they've expected to go from 0% to 3% or slightly higher, 12 rate cuts. So that change in fed policy from, “We're probably not going to hike rates at all,” to “Actually, we're going to hike rates a lot. They're going to go up to 3%.” That change, that large change over such a very short time period as far back as we can see in recent financial history, that pivot as we call it, that change in the fed’s perspective has been the largest change in the shortest amount of time. That has driven short rates and long rates up at the same time which has led to these large drawdowns, meaning price drops in fixed income with treasuries down at their lowest point. Basically at the lowest level we've ever seen in the history of Bloomberg data back to January ‘73. Even short bonds, which are usually relatively insulated from interest rate moves, were down almost 6% from the peak. Again, that is the largest drop in Bloomberg data back to January 2000 but again, we counsel on that don't think of the first order effect of just seeing bond prices down. We recommend high quality fixed income for the yield it delivers, for the stable income, for its diversification benefit, not just in terms of bond prices going up as stock prices go down. That's a nice effect to have, but really how fixed income diversifies your portfolio is by giving you steady reliable income year in and year out as long as you're in high quality fixed income and over time that steadier yield will diversify your portfolio. While higher rates decrease the market value of your high quality fixed income investments, they don't decrease its principal value which if you don't get a default, which is very unlikely in treasuries, and very small in terms of credit losses in terms of either investment grade municipals or corporates, as long as you hold to term through the vehicle you hold, you’ll generally get the yield at which you acquired that portfolio. Again, if the market is correct and the fed is going to stop hiking rates at around the 3% level, potentially cut rates, then if possible in our opinion that while not all, we could still see rates move up from here and that's one likely path, the majority of price drops might be behind us. Again, do not look just the first order effects, look at the opportunities now to potentially add to fixed income, get back to your strategic and/or tactical weights, look at opportunities in high quality fixed income. In particular, as we look at the municipal market, we've seen some price action there that has been relatively large, both relative to treasuries and to investment grade corporates where at the end of last week, we had 10 year municipal bonds on average trading in higher yields than US treasuries even before the tax effect. So look at the drawdowns of fixed income, potentially find opportunities to reallocate your strategic and tactical targets, look for opportunities where these higher yields are actually an opportunity to balance your portfolio. Bring us to our third main point. Obviously, we've seen a massive drawdown in balanced portfolios and again, if we look at Bloomberg data for 60/40 portfolio - you know 60% equities, 40% fixed income - looking at the US, we’re down more than 15% from the peak and that's obviously concerning for investors particularly with a large component of that being fixed income prices dropping but as we look back over the last 15 years, these types of drawdowns while rare, there's things you see from time to time even without a crisis or a recession. If you go back again to the 2018 period where the market thought there was a higher chance of recessionary risk and we had that almost 20% correction December 2018, we did see diversified portfolios off more than 11%. Again, so the current draw down to 60/40 portfolios slightly more than 15% is sort of constant with that. There have obviously been other periods in crises whether it's the global financial crisis, the Covid crisis where we've seen more than 20% or 30% drops in diversified portfolios. So while many have counseled that maybe this should be the end of a 60 portfolio or equities and bonds will now be positively correlated for the foreseeable future, we would caution on that. Again, the future is uncertain. All these things are possible, but over time for the last three decades the diversification benefit of equities and fixed income has reasserted itself. So don't conflate a near term change in that correlation with a long term change. It is our belief that that correlation, that bonds protecting you in a economic scenario that is worse than you expect will continue to assert itself and we have seen signs in markets over the last two weeks that that correlation between bonds and equities is reasserting itself with the 10 year having moved from its highest yields in the last year to two years to come back down. So we would counsel against overreacting to thinking that equities and bonds together are both going to continue to go down and go down and go down. Again, the diversification benefit generally reasserts itself. It is our belief that it will reassert itself. While two weeks is not enough data to say that's conclusive, that re-move back to equities and fixed income being inversely correlated is what we'd expect and again, over longer periods of time we still expect fixed income to be a very good diversifier. So this does not mean to not tilt and not to add potentially assets that are better exposed to inflation, but again, it does not mean to abandon fixed income or abandon your classic building blocks of your portfolio of equities and fixed income. With that, we'll wrap up the upfront comments for today's call. Thanks again for joining us.
Operator: Please see important disclosures provided on this page.
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